PIMCO: Cost of capital in Brazil falls, but so do businesses’ returns and cash flows … thanks to the government’s heavy hands

(An excerpt from PIMCO’s latest note on the real impact of lower rates in Brazil).

Bottom Line:

​The Brazilian government wants to keep interest rates low but also guard against inflation; so the authorities have moved down a path of “macro-prudential” measures, with a broad range of implications for equity investors.

In reality, as the cost of capital in Brazil falls, the returns and cash flows from regulated businesses are coming under pressure.

In this environment, we find that consumer businesses are the most appealing, especially if growth accelerates.

Lower interest rates in Brazil are not a clear-cut positive for equities. In our view, the government’s so-called “macro-prudential” measures and increased socialization of shareholder profits by state-owned enterprises are putting profit pools in Brazil at risk. In the long term, reducing the cost of doing business in Brazil will be positive, but it may come at the expense of corporate profitability.

Brazilian interest rates are at historical lows, as Figure 1 shows. The Selic overnight rate has touched 7.4%, well below the levels seen after the bankruptcy of Lehman Brothers in 2009. The government, keen to ensure that the very high real interest rates we’ve seen historically in Brazil do not return, has undertaken a range of measures to achieve this. In PIMCO’s view, interest rates in Brazil will stay lower for longer. So what are the implications for Brazilian equities?

At first glance, you’d think the impact of low interest rates would be positive: As the cost of capital falls, equity valuations should rise, economic growth should accelerate and arguably, this should translate into better earnings growth for companies.

The reality, we believe, is more nuanced. The Brazilian government wants interest rates to remain low, but it also wants to guard against the threat of rising inflation. As a result, the authorities have moved down a path of “macro-prudential” measures instead, with a broad range of implications for equity investors. In reality, as the cost of capital in Brazil falls, the returns and cash flows from regulated businesses are coming under pressure.

The returns for regulated industries are particularly susceptible in the current environment. Historically, industries such as utilities and toll-roads have benefited from declining interest rates, but the government is clearly focused on sharing those benefits with the consumer. For example, the government recently announced a plan to reduce electricity prices by setting new conditions when concession contracts are renewed. These conditions are within the scope of the existing contracts but are more onerous than the equity market had expected. The high returns on concession renewals enjoyed by Brazilian generators look set to decline, potentially marking the end of a “free lunch” in Brazil.

The cost of credit in Brazil is distorted by state-owned banks, notably the Brazilian development bank BNDES, Caixa Economica Federal and Banco do Brasil. Brazilian banks have seen their profitability decline for the past several years, but the state-owned banks have begun to accelerate that trend by becoming increasingly aggressive in providing credit at lower interest rates; private sector banks have begun to follow. So as the Selic (Brazilian overnight bank rate) has come down, so too have net interest margins. The sustainable return-on-equity (ROE) for these banks remains a key debate among equity investors: The private banks remain convinced that 20% is sustainable, but we recognise this may be challenging (see Figures 2 and 3). We do believe that lower returns can be offset by higher volumes, notably in mortgages.

4. The government has introduced a range of policy measures to stimulate growth, including cutting taxes on the purchase of cars and white goods (primarily household appliances). Most recently, we’ve also seen a cut in the payroll tax in return for a tax on domestic sales. Each of these moves has immediate and potentially significant implications for a range of sectors; Figure 4 shows the immediate impact on the auto sector.

As investors, we are focused on the return profile of a business and the sustainability of cash flow generation, and we recognise the challenges this scenario in Brazil poses. In some cases, we need to see profit expectations revised down before we revisit certain sectors. In particular, we need to be wary of share prices that imply permanently high returns on capital, especially in sectors with regulatory uncertainties.

State-owned enterprises are increasingly being called upon to invest against the best interests of minority shareholders. We see this in the larger investment budgets of the big energy and commodity companies, in their domestic pricing, in changes to their tax regimes and in their falling margins (see Figures 5 and 6). We now see a market where state-owned commodity companies will happily invest in projects with negative net present value and redeploy all their free cash flow for unprofitable growth; where state-owned financials will cut their pricing to gain market share and stimulate growth, despite rising non-performing loans and a significant increase in credit penetration; and where regulated businesses will be less profitable than they have been in the past.

In our view, the list of appealing investments grows ever shorter. In this context, the return profile of consumer businesses looks more appealing. The dilemma here is valuation. Consumer staples, for instance, trade at record multiples compared to the emerging market universe. But if you find yourself eliminating the alternatives, then the consumer may be all that’s left, and if growth accelerates, this may be a good place to stay.